Family law attorneys could see some big changes in the treatment of alimony and business valuation thanks to proposed tax legislation that is making its way to the Senate floor.
On November 16, 2017, the House passed the Tax Cuts and Job Act, which has some serious implications for divorce planning. While the proposed bill could change during the reconciliation process, it’s important for family law attorneys to understand the various provisions of the proposed bill and how it might impact divorcing clients.
This article will focus on two of the provisions that could impact divorcing couples: the repeal of the tax deduction for alimony payments and the potential impact on business valuations.
Repeal of the Tax Deduction for Alimony Payments
One of the more highly publicized sections of the bill is the repeal of the tax deduction for alimony payments.
Given the current difference in the tax treatment of alimony versus child support, this is often a significant negotiating item in any settlement. As a result, any change in the tax treatment could have far-reaching consequences.
Under current tax law, in most cases the spouse paying the alimony is in a considerably higher tax bracket than the spouse receiving the money. The difference between the tax brackets provides a benefit to the spouse paying the alimony and an even greater benefit to the one receiving it.
Essentially, the spouse receiving alimony is getting considerably more in actual dollars than the spouse paying it. Under the proposed bill, the elimination of the tax deduction would eliminate this “divorce subsidy,” which allows for a divorced couple to achieve a better tax result for payments between them than a married couple can achieve.
It is also important to look at the proposed timing of the changes. First, the bill would go into effect for divorces finalized AFTER December 31, 2017. Any divorce agreement made in 2017 would have the benefit of being grandfathered in and, therefore, would still retain the tax deductibility of alimony.
Second, the bill also addresses modifications of existing agreements made after 2017. The bill states that the modification would need to include clear language to adopt the new tax law in order for a recipient to get tax-free treatment. As a modified support order is not automatically grandfathered in for the tax deductibility of alimony, this may result in a battleground issue for future modifications, especially for the spouse who was paying alimony and receiving the tax deduction.
Higher Business Valuations
The proposed bill lowers individual and corporate tax rates. A byproduct of this is the impact that these lower rates would have on business valuations.
For business owning spouses, their interest in a closely-held company typically is one of the biggest assets in a marital estate.
The income approach used in many business valuations is frequently based on after-tax cash flows. For both C corporations and pass-through entities (which have additional provisions in the bill), the reductions in the corporate and individual tax rates would result in a naturally higher after-tax cash flow. This higher after-tax cash flow would then result in higher business values.
What To Do Next
The proposed bill has significant implications for divorcing couples. Family law attorneys should continue to be aware of what’s coming down the pipeline in the way of tax law changes.
The bottom line – financial strategies for your clients will need to change should the bill become law.
Our Forensics & Litigation Support Group can help. Richard Wolf, CPA, CGMA, CFE, CVA, specializes in providing business valuation, forensic accounting and litigation support for family law attorneys. Contact him online or call 800.899.4623.